Chapter 4

ANALYSING FINANCIAL PERFORMANCE

OUTLINE

Financial Ratios
Du Pont Analysis Standardised Financial Statements Applications of Financial Analysis Using Financial Statement Analysis

Going Beyond the Numbers

OUTLINE Financial Ratios Comparative Analysis Du Pont Analysis Problems in Financial Statement Analysis Guidelines for Financial Statement Analysis

Horizon Limited: Profit and Loss Account for the Year Ending 31st March 20X1
Net sales Cost of goods sold Stocks Wages and salaries Other manufacturing expenses Gross profit Operating expenses Depreciation General administration Selling Operating profit Non-operating surplus/deficit Profit before interest and tax Interest Profit before tax Tax Profit after tax Dividends Retained earnings Per share data ( in rupees) Earning per share Dividend per share Market price per share Book value per share 20X1 701 552 421 68 63 149 60 30 12 18 89 89 21 68 34 34 28 6 2.27 1.80 21.0 17.47 17.07 (Rs. in million) 20X0 623 475 370 55 50 148 49 26 11 12 99 6 105 22 83 41 42 27 15 2.80 1.80 20.0

Horizon Limited: Balance Sheet as on 31st March 20X1

(Rs. in million) 20X1 I. Sources of funds 1. Shareholders' funds (a) Share capital (b) Reserves and surplus 2. Loan funds (a) Secured loans (i) Due after 1 year (ii) Due within 1 year (b) Unsecured Loans (i) Due after 1 year (ii) Due within 1 year II. Application of funds 1. Fixed assets 2. Investments (a) Long term investments (b) Current investments 3. Current assets, loans and advances (a) Inventories (b) Sundry debtors (c) Cash and bank balance (d) Loans and advances Less: Current liabilities and provisions Net current assets Total 262 150 112 143 108 35 69 29 40 474 330 15 12 3 234 105 114 10 5 105 129 474 20X0 256 150 106 131 29 40 25 10 15 412 322 15 12 3 156 72 68 6 10 81 75 412

LIQUIDITY RATIOS
Current Ratio
Current assets Current liabilities Acid-Test Ratio Quick assets (237 105) = = 0.73 Current liabilities 180 Cash Ratio Cash and bank Current + investments balances Current liabilities (10 + 3) = 0.07 = 180
=

237 180

= 1.32

LEVERAGE RATIOS
Debt-equity Ratio
Debt = 212 = 0.809

Equity

262

Debt-asset Ratio Debt 212

=
Assets 474

= 0.45

Interest Coverage Ratio

Profit before interest and tax

= Interest

89
= 4.23 21

TURNOVER RATIOS
Inventory Turnover Cost of goods sold 552 = Average inventory (105 + 72)/2 = 6.24 Debtors Turnover Net credit sales 701 = = 7.70 Average debtors (114 + 68)/2 Fixed Assets Turnover Net sales 701 = = 2.15 Average net fixed assets (330 + 322)/2
Total Assets Turnover Net sales 701 = = 1.58 Average total assets (474 + 412)/2

PROFITABILITY RATIOS
Gross Profit Margin Ratio
Gross profit Net sales 149

701

= 0.21 or 21 percent

Net Profit Margin Ratio Net profit 34

Net sales

701

= 0.049 or 4.9 percent

Return on Assets (ROA) Profit after tax Average total assets

34 (474 + 412)/2

= 0.077 or 7.7 percent

PROFITABILITY RATIOS
Earning Power
Profit before interest and tax Average total assets Return on Capital Employed Profit before interest and tax (1 Tax rate) Average total assets Return on Equity = 89 = 0.201 or 20.1 (474 + 412)/2 percent

89 (1 0.5)
(474 + 412)/2

= 0.101 or 10.1 percent

Equity earnings
Average equity

34
= 0.131 or 13.1 (262 + 256)/2 percent

VALUATION RATIOS
Price-earnings Ratio Market price per share
= Earnings per share 2.27 Price change + Initial price Initial price 21.0 = 9.25

Yield
Dividend

Dividend yield 1.87 = 9.35% 20.0

Capital gains/losses yield 1.0 = 5% 20.0

Market Value to Book Value Ratio Market value per share 21.00 = = 1.20 Book value per share 17.47

COMPARISON WITH INDUSTRY AVERAGES

Ratios
Liquidity Current ratio Acid-test ratio Leverage Debt-equity ratio Debt-ratio Interest coverage ratio Turnover Inventory turnover Accounts receivable turnover Fixed assets turnover Total assets turnover Net sales 6.24 Average inventory Net credit sales 7.70 7.50 2.23 6.43 Debt 0.81 Equity Debt 0.45 Assets PBIT 4.23 Interest 4.14 0.56 1.25 Current assets 1.32 Current liabilities Quick assets 0.73 Current liabilities 0.69 1.26

Formula

Horizon Limited

Industry Average

Average accounts receivable Net sales

2.15 Average net fixed assets Net sales 1.58 Average Total assets 1.26

Ratios
Profitability
Gross profit margin ratio Net profit margin ratio Return on assets Earning power Return on capital employed Return on equity Valuation Price-earnings ratio Yield

Formula
Gross profit Net sales Net profit

Horizon Limited
21.0% 4.9%

Industry Average
18.0% 4.0% 6.9% 17.7% 8.8% 11.9%

Net sales Net profit 7.7% Average total assets PBIT 20.1% Average total assets PBIT (1T) 10.1%

Average total assets Equity earnings

13.1% Average net worth Market price per share 9.25 9.26

Earnings per share Dividend + Price change

14. 0% Initial price Market price per share Market value to book value ratio 1.20 1.16 14.1%

Book value per share

TIME SERIES OF CERTAIN

FINANCIAL RATIOS
1 Debt-equity ratio Total assets turnover ratio Net profit margin (%) Return on equity (%) Price-earnings ratio 0.91 1.51 8.8 25.4 18.6 2 0.98 1.59 11.6 30.7 15.3 3 0.65 1.58 9.8 24.5 10.3 4 0.61 1.53 6.6 16.7 7.1 5 0.81 1.58 4.9 13.1 9.3

DUPONT ANALYSIS
Basic Du Pont Analysis
Net profit = Net profit x Net sales

Average total assets Net sales ROA = NPM

Average total assets x TATR

Extended Du Pont Analysis

Net profit = Equity Sales Net profit x Average total assets Sales x Average equity Average total assets

ROE

NPM

TATR

x 1/(1 DAR)

DU PONT CHART APPLIED TO HORIZON LIMITED

Net Sales +/- Non operating Surplus/Deficit 701

Net Profit 34 Net Profit Margin 4.9%

Total Costs 667

Net Sales 701

Return on Total Assets 7.7 %

X
Net Sales 701 Total Assets Turnover 1.58

Average Fixed assets 326

Average Total Assets 443

+
Average Investments 15

+
Average Net Current Assets 102

EXTENSION OF THE DU PONT CHART

Return of Equity 13.1%

Return of Assets 7.7%

Average Total Assets To Average Equity Ratio 1.70

COMMON SIZE FINANCIAL STATEMENTS

Part A : Profit and Loss Account
Regular (in million) 20X0 20X1 Rs.623 Rs. 701 475 552 148 149 105 89 22 21 83 68 41 34 42 34 Common Size (%) 20X0 20X1 100 100 76 79 24 21 17 13 4 3 13 10 7 5 7 5 Common Size (%) 20X0 20X1 62 55 38 45 100 100 78 70 4 3 18 27 100 100

Net sales Cost of goods sold Gross profit PBIT Interest PBT Tax PAT

Part B: Balance Sheet Regular (in million) 20X0 20X1 Shareholders funds 256 262 Loan funds 156 212 Total 412 414 Fixed assets 322 330 Investments 15 15 Net current assets 75 129 Total 412 474

COMMON-BASE YEAR FINANCIAL STATEMENTS

Part A : Profit and Loss Account
Regular (in million) 20X0 20X1 Rs.623 Rs. 701 475 552 148 149 105 89 22 21 83 68 41 34 42 34 Common Base Year (%) 20X0 20X1 100 113 100 116 100 101 100 85 100 95 100 82 100 83 100 81 Common Base Year (%) 20X0 20X1 100 102 100 136 100 115 100 102 100 100 100 172 100 115

Net sales Cost of goods sold Gross profit PBIT Interest PBT Tax PAT

Part B: Balance Sheet Regular (in million) 20X0 20X1 Shareholders funds 256 262 Loan funds 156 212 Total 412 474 Fixed assets 322 330 Investments 15 15 Net current assets 75 129 Total 412 474

APPLICATIONS OF FINANCIAL ANALYSIS Financial ratios may be employed to: Assess corporate excellence Judge creditworthiness Forecast bankruptcy Value equity shares Predict bond ratings Estimate market risk

PROBLEMS IN FINANCIAL

STATEMENT ANALYSIS
Heuristic and Intuitive Character

Development of Benchmarks
Window Dressing Price Level Changes Variations in Accounting Policies Interpretation of Results Correlation among Ratios

GUIDELINES
USE RATIO TO GET CLUES TO ASK THE RIGHT QUESTIONS
BE SELECTIVE IN THE CHOICE OF RATIOS EMPLOY PROPER BENCHMARKS KNOW THE TRICKS USED BY ACCOUNTANTS

READ THE FOOT NOTES UNDERSTAND HOW THE RATIOS ARE INTERRELATED REMEMBER FSA .. ODD MIXTURE OF ART & SCIENCE

LOOKING BEYOND THE NUMBERS

1. ARE THE COMPANYS REVENUES TIED TO ONE KEY
CUSTOMER ? 2. TO WHAT EXTENT ARE THE COMPANYS REVENUES TIED TO ONE KEY PRODUCT ? 3. TO WHAT EXTENT DOES THE COMPANY RELY ON A SINGLE SUPPLIER ? 4. WHAT PERCENTAGE OF THE COMPANYS BUSINESS IS GENERATED OVERSEAS ? 5. COMPETITION 6. FUTURE PROSPECTS 7. LEGAL AND REGULATORY ENVIRONMENT

SUMMING UP
Financial statement analysis can provide valuable insights into a firms performance and position.
The principal tool of financial statement analysis is financial ratio analysis. Financial ratios may be divided into five broad categories: Liquidity ratios Leverage ratios Turnover ratios Profitability ratios Valuation ratios Generally, the financial ratios of a company are compared with some benchmark ratios.

The Du Pont chart is a popular tool of financial analysis. It provides insights into the determinants of the return on equity
There are certain problems and issues in financial statement analysis that call for care, circumspection, and judgment.